how to understand the eu’s growing rulebook on sustainable

In focus

Why the EU is actingClimate change is getting harder to ignore. In particular, the economic and social costs are becoming more tangible. The European Environment Agency estimates that the average economic loss from climate-related weather extremes was €12.5 billion a year between 2010 and 2019 and that disasters caused by climate-related extremes accounted for over 81% of the monetary losses caused by natural hazards over the period 1980-2019 in the EU.

After being repeatedly confronted with the real consequences of climate change, governments around the world have agreed to take action both together and individually. The most significant (global) milestone is the Paris Agreement, which is a commitment by individual countries, agreed at COP 21 in Paris in 2015 and entered into force in 2016, to limit the increase in the global average temperature to below 2°C.

The EU has followed this up with an elaborate framework that is its own ‘call to arms’, known as the EU Green Deal. The Green Deal is about setting a goal and the way towards achieving that goal. The goal the EU has set for itself is to have net zero emissions by 2050. It means that, by 2050, the EU will be offsetting any greenhouse emissions it produces.

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How to understand the EU’s growing rulebook on sustainable investingJanuary 2021

In the last few years new words have been invading our everyday vocabulary. We have gone from ‘climate change’ and ‘green economy’ to the more specialised ‘sustainability’ and ‘integration’ and the utterly bizarre ‘principal adverse impact’ and ‘taxonomy’. What is happening?

Policymakers have realised that tackling climate change and all its consequences will take a lot of effort. This effort has to open many fronts at the same time and has to change everything we do as consumers, savers and investors. For the world of investment, this effort has resulted in multiple regulatory changes that are complicated and hard to understand.

The purpose of this paper is to explain what is happening in the EU, help people look through the sometimes-strange-sounding terminology, explain who needs to do what, and why all this contributes towards the EU’s ambition to battle climate change.

Anastasia PetrakiHead of Policy Research

Figure 1: Key milestones in the EU’s ambition for a more sustainable future

Source: Schroders.

2015 UN Sustainable Development Goals– 17 goals and 169 targets– Social and environmental objectives to achieve a better future for all

2020-21 Covid-19 recovery plan– Support national recovery plans if aligned with digital and green agenda (30% of the recovery package funds to fight climate change)

2018 EU Sustainable Finance Action Plan– 10 action points to finance transition to sustainable economy and manage environmental and social risks

2019 EU Green Deal– Carbon neutrality by 2050– Combination of financial and real economy measures

2016 Paris Agreement– Limit annual increase in global average temperature to less than 2 degrees

https://www.eea.europa.eu/data-and-maps/indicators/direct-losses-from-weather-disasters-4/assessment

Achieving ‘net zero’ will not be simple. To begin with, the world is on track to see temperatures rise by 3.8oC according to our research – almost double that of the Paris target. So there is a great sense of urgency for significant change.

The Green Deal has identified a very long list of things that need to change in the real economy. Examples include how we build houses, how we travel from A to B, how the things we buy in the supermarket are packaged, where the energy for cooking and heating comes from, how long our smartphone batteries last and so on. Things like reducing micro-plastics in product manufacturing or banning plastic straws will seem like a very small change in comparison.

Box 1 (next page) shows in broad terms which areas of the real economy the Green Deal is targeting and examples of some of the changes we can expect.

Paying the billCarrying out all these plans comes with a financial cost. For example, if we want to have more energy-efficient electric vehicles on our roads, it is not enough that companies produce such cars that are affordable and have a good design. We need to have the corresponding battery charging infrastructure so that people can easily recharge at home or at work (or anywhere else for that matter) and this electricity should come from renewable energy sources too. McKinsey estimated that the EU would need a cumulative 15 million chargers and roughly $17 billion by 2030 to meet the expected demand for electric car chargers. Now imagine the investment that is needed to change not only our personal transport but all the other aspects of the real economy.

The EU has estimated this at around €260 billion per year in the next decade which translates to €2.6 trillion by 2030 alone. And, of course, there is always the possibility of upward estimates in the future. The European Commission has put quite some thought into this. Drawing from various public sources such as the EU budget, the European Investment Bank and even a part of the Covid recovery package, it will invest around €1.2 trillion. This is a little under half of the €2.6 trillion total, meaning that the other half will need to come from the private sector (see Figure 2).

Figure 2: Financing the €2.6 trillion transition to a more sustainable economy by 2030

Schroders, European Commission Green Deal Investment Plan, European Commission Covid recovery plan.

Figure 3: The EU Sustainable Finance Action Plan

Source: Schroders.

Privatesector

53%

Publicsector

47%

Green Deal investment

plan38%

Covid fund9%

The Commission has concrete ideas for the private sector involvement too. It has put together a plan of action that specifically targets the financial services sector. This is known as the EU Sustainable Finance Action Plan which was unveiled in 2018 and lists 10 actions that are needed to achieve three goals (see Figure 3).

A renewed plan with new actions to increase private investment in sustainable projects to support the Green Deal goals is expected in early 2021.

If we had to boil the Sustainable Finance Action Plan down to one ultimate objective, it would be how to shift money towards more sustainable projects and businesses so that we transition to a low-carbon economy faster.

It is worth noting that this focus on the environment is key to the EU agenda and the absolute driving force. Social considerations appear in-between, for example there are references to a ‘just transition’ where ‘no one is left behind’. But social is not the ultimate objective. The ultimate objective is tackling climate change and the EU is trying to achieve carbon neutrality while taking social issues into consideration.

Reorienting capital flows towards sustainable investment

10 actions

Mainstreaming sustainability into risk management

Fostering transparency and long-termism

Establish EU Sustainable Taxonomy

Develop sustainability benchmarks

Incorporate sustainability in investment advice

Foster investment in sustainable projects

Create standards and labels

Integrate ESG in ratings and market research

Foster sustainable corporate governance

Strengthen sustainability disclosure and accounting

Incorporate sustainability in prudential requirements

Clarify institutional investors' duties as shareholders

2

https://www.schroders.com/en/about-us/corporate-responsibility/sustainability/climate-progress-dashboard/

https://www.mckinsey.com/industries/automotive-and-assembly/our-insights/charging-ahead-electric-vehicle-infrastructure-demand

https://ec.europa.eu/commission/presscorner/detail/en/qanda_20_24

https://ec.europa.eu/info/strategy/recovery-plan-europe_en#nextgenerationeu

Box 1: Overview of the EU Green Deal

Examples of things that the EU Green Deal wants to change

Base the power sector largely on renewable sources, phasing out coal and decarbonising gas

Decarbonisation and modernisation of energy-intensive industries, such as steel, chemicals and cement

Encourage smart infrastructure. For example, smart grids, hydrogen networks or carbon capture, storage and utilisation, energy storage

Support ‘sustainable products’: prioritise reducing and reusing materials before recycling, ‘right to repair’, curb the built-in obsolescence of devices, in particular for electronics

Digitalisation: distance monitoring of air and water pollution, optimising use of energy and natural resources, predict environmental disasters

Double the annual renovation rate of the building stock (now between 0.4% and 1.2%)

90% reduction in (road, rail, aviation, and waterborne) transport emissions by 2050

Shift most of the 75% of inland freight carried today by road onto rail and inland waterways (increased capacity needed first)

One million public recharging and refuelling stations for the 13 million zero-/low-emission vehicles expected by 2025

At least 40% of the common agricultural policy’s budget and 30% of the Maritime Fisheries Fund to contribute to climate action

Give consumers better information on where food comes from, including details on nutritional value and environmental footprint

Reward farmers for improved environmental and climate performance, including managing and storing carbon in the soil, and better nutrient management to improve water quality and reduce emissions

Remove subsidies for fossil fuels, shift the tax burden from labour to pollution, lower VAT for organic food

Source: Schroders.

What is the EU Green Deal and might it impact business?

Sustainable Transport

Building Renovation

Clean Energy

Circular Economy/Sustainable Food

• Renewable energy• Transmission grids• Distribution grids• Batteries• Hydrogen • Carbon capture & storage

• Sustainable agriculture• Sustainable food• Reusability

• Electric vehicles supply chain• Charging infrastructure• Rail • Semi-conductors• Hydrogen

• Climate-proofing• Energy efficiency• Heating technology

The EU Green Deal aims to make Europe climate neutral by 2050

Ambitious target will impactalmost all sectors of the economy

Includes around 50 policiesand initiatives50

How will industries and companies be affected?We’ve mapped policy areas to four key investment themes

Read more in our SustainableInvestment Report Q3 2020

Source: Schroders, European Commission, The European Green Deal.

3

https://www.schroders.com/getfunddocument/?oid=1.9.3897455

https://eur-lex.europa.eu/legal-content/EN/TXT/?qid=1596443911913&uri=CELEX:52019DC0640#document2

Making savings a force for goodThe intention behind the Sustainable Finance agenda is to create a regulatory framework for financial services in general and the investment management sector in particular, that facilitates and even accelerates the flow of money from individual savers towards sustainable projects and businesses.

Currently, there are many obstacles that stand in the way. The market is fragmented. There are many different investment products out there using acronyms that only industry insiders understand. Some countries have their own labelling system. People can’t really tell from product documents if something contributes towards sustainability or not. No one along the way asks investors if they would prefer to invest in something that

helps the transition. Companies don’t report enough on their activities for people to know how sustainably (in respect to the environment) their business is run.

Every bit of regulation connected to the Sustainable Finance Action Plan is supposed to remove or overcome these obstacles. It should make it easier for people’s savings to reach projects and businesses whose activities will help the transition towards a greener economy. In a way, it is a means to an end but not the end itself.

Figure 4 provides an overview of the regulatory activity triggered by the EU Sustainable Finance Action Plan. Appendix 1 shows which regulation applies to whom and the timeline of key changes.

Taxonomy Regulation

Defines sustainable economic activities. In the investment world, it judges what qualifies as a sustainable product. The current version focuses on environmental sustainability but there will be a Social Taxonomy to follow. See Appendix 2 for more details.

Sustainable Finance Disclosures Regulation (SFDR)

Ensures that everyone along the investment chain (asset managers, pension funds, insurers, adviser) explains how they think about sustainability and the impact of their investments (or advice). This will apply on both an entity and product level. See Appendix 3 for more details.

Delegated acts (UCITS/AIFMD/ MiFID II)

Ensures that investment product providers think about sustainability in their operations, product governance and risk management. This will allow them to make the necessary disclosures under SFDR. Asset managers are already subject to these EU regulations and these amendments do not propose new organisational or conduct rules. Instead the aim is to amend existing rules under these directives, to ensure that providers take account of sustainability risks as part of compliance with the existing rules.

Suitability (MiFID II and Insurance Distribution Directive)

Requires that advisors have an explicit discussion with their clients about the latter’s sustainability preferences. By having this as part of the standard interaction, it is hoped that it will help investors who already have a preference towards sustainable investing to get advice on the right products for them and the nature of their preference. It is also hoped that investors who don't have such a preference will become aware of and think of sustainability and perhaps invest in sustainable products in the future.

EcolabelIntroduces a clear label for all investment products to help both investors and advisers pick a product. Currently there is work on the possibility of labelling financial products as ‘green’ or ‘environmentally focused’ using the Taxonomy Regulation and the Green Bond Standard.

Prudential Changes will require large banks, pension funds, insurers and asset managers to think about sustainability in their prudential framework, that is, how they assess financial stability risks.

Benchmarks Introduces two new benchmarks: the EU climate transition benchmark and the EU Paris-aligned benchmark. The intention is that these can serve as reference benchmarks for actively managed and index-tracking investment products.

Non-Financial Reporting Directive (NFRD)

Work is underway to amend the existing company reporting rules within NFRD that apply to large listed companies. The changes will require companies to report additional sustainability information and could be extended beyond large listed companies. NFRD has already been amended by the Taxonomy to require companies to report the proportion of their economic activities that can be classified as environmentally sustainable by the Taxonomy.

Shareholder Rights Directive II (SRD II)

Clarifies the duties of asset managers, asset owners and companies for stewardship. The ultimate aim is to promote greater dialogue and engagement.

Sustainable Corporate Governance

This workstream is currently under development with various studies and consultations done so far to try and establish whether there is undue short-termism in capital markets. There is no regulation arising from this yet but policymakers are exploring several options. The overall aim is to foster long-termism as there have been concerns that time horizons have been too short to allow for the long-term investment and projects needed to transition to a greener economy.

EU Green Bond Standard

Intends to enhance the transparency, comparability and credibility of the green bond market. The aim is to encourage both issuance of and investment in green bonds in the EU. It will be linked to the Taxonomy.

Credit ratingsThe EU regulator (ESMA – European Securities and Markets Authority) has produced guidelines (not rules) for sustainability disclosures in credit ratings. The goal is to integrate sustainability into ratings so that a company's approach to sustainability is linked to its cost of capital.

Figure 4: An overview of regulatory change driven by the EU Sustainable Finance Action Plan

Source: Schroders.

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Some of it, such as the Taxonomy Regulation and the Sustainable Finance Disclosures Regulation (SFDR), is completely new.

Some of it amends existing regulation to add a sustainability aspect to it. This includes the changes in the so-called Delegated Acts that set the technical standards for the providers of investment products such as UCITS and alternative investment funds (AIFMD), and portfolio management (MiFID II). It also includes the changes in the Benchmarks Regulation to create appropriate reference benchmarks for investment products with sustainability features.

The disruptors on this list are the Taxonomy Regulation and SFDR. Appendix 2 outlines the Taxonomy framework using three pictures, while Appendix 3 explains the SFDR requirements using three quite dense tables (which just serves to show how extensive the requirements are).

In a nutshell, the Taxonomy creates a science-based toolkit that classifies which economic activities are environmentally sustainable and which are not. By ‘environmentally sustainable’ the regulation means activities that do not harm the environment and contribute towards tackling climate change.

Having a common language and understanding of sustainability and associated terms is crucial. Some think that the reason the market for sustainable investment has not really taken off yet (not even now) is that it is too fragmented, with each company having its own narrative and every market participant having a different understanding of what commonly used terms mean.

The Taxonomy will apply across the EU and so is supposed to fix this fragmentation. This means that it should be easier to identify the market for sustainable investment, compare products, and prevent greenwashing (which means being ‘green’ in name but not in substance).

Why is a Taxonomy important? Imagine trying to buy a car without a common understanding of what a family or a sports car is. That said, with a car the difference is at least visible. With an investment product, it is not. So it is even more important that we all have a high degree of confidence that we know what we are buying before we buy it.

That is why we need disclosures that tell us what something is (SFDR) in a language that we all understand and use the same way (Taxonomy). SFDR, in particular, touches upon three types of information (Figure 5):

– Could sustainability factors have an impact on the value of an investment?

– Could an existing investment have a negative impact on sustainability factors? This is what SFDR calls ‘principal adverse impact’

– If a product has sustainability features, what are these and how do they work?

The first two are kind of the opposites sides of the same coin. The first relates to whether sustainability factors, which is another way of saying environmental, social and governance (ESG) factors, are taken into account when investing because they can affect the value of the investments (also known as integration of sustainability risks). On the other side, we have ‘principal adverse impact’ which is the possibility that the money that we invest is somehow connected to activities that may harm the environment or social factors.

In effect, SFDR makes providers of investment products think about their own business model and how they approach the question of sustainability. Do they give a thought to ESG factors when they allocate money? Do they examine whether the companies they have invested in engage in activities that perhaps harm the environment or perpetuate social problems?

These providers will not only have to think and decide on these questions. They will also have to set up all their internal processes and operations to really do it (which is what the Delegated Acts are about) and then report these to the wider world (which is what SFDR is about).

All this should make asset managers, asset owners, and advisers completely re-think their business and attach a ‘think about sustainability’ tag to everything they do. In turn, this should make them more mindful and aware of sustainability altogether. From this change of mind-set there could follow a more general tilt towards integration which should become the norm.

But there is more. SFDR will make investment product providers think about their products too. There are many ways to sustainability. A product may exclude sectors on the basis of environmental principles. Or it may choose to invest only in companies which it views as strong in terms of sustainability, or which have the highest sustainability ratings or credentials. Or to use engagement to influence companies to turn to more sustainable practices.

SFDR defines products in very specific terms (Figure 6).

Are ESG factors a consideration when analysing what to invest in and how much? This would make it an ‘Article 6’ product.

Does the provider market the product on the basis of a sustainability characteristic, such as it picks only those with the highest sustainability credentials, or it has a policy to engage with holdings to improve those credentials? Then it is probably an ‘Article 8’ product.

Figure 5: The three types of information that SFDR requests

Source: Schroders.

ESG

Investment risk to sustainability

Could any of the existing investments

have a material negative impact

on the environment or society?

“Principal adverse impact”

Sustainability risk to investment

Are there sustainability

factors that could materially affect the value/return of an

investment?

“Integration of sustainability risks”

Sustainability product features

If a product is marketed on the

basis of sustainability features, how does it work and how has it

performed?

“Article 8 and Article 9 products”

Figure 6: New classification system for investment products

Source: Schroders.

ESGArticle 6: have integrated sustainability risks or explain why they have not done so (everything that is not Article 8 or Article 9 product)

Article 8: promoted on the basis of asustainability characteristic

Article 9: have a sustainability objective

5

Does the product try to deliver a return (which is the raison d’être of all investment products) while trying to also achieve an outcome of a sustainability nature? Then it is an ‘Article 9’ product.

The reason these products are defined as ‘Articles’ is that they are defined in (literal) articles in the SFDR regulation. Each article (6, 8, 9) in this regulation gives high-level information on what characteristics these products have.

Strictly speaking, Article 6 products do not necessarily integrate sustainability risks. The regulation refers to a ‘comply or explain’ approach on integration, meaning that a provider has two choices. One is putting some thought into any environmental, social or governance factors that could affect the value of the investments. The other is having a really good explanation as to why these factors are not relevant, meaning that the provider has evidence that they do not pose a risk for the investment value.

It is not easy to imagine many cases where there is no ESG factor that is relevant for investment decision making. So this requirement raises the bar across all EU investment products to at least integrate ESG. Which, in turn, means that integration has suddenly gone from being ‘that little extra’ to ‘run-of-the-mill’.

A lot of attention is currently on which products would fit into the Article 8 and Article 9 categories. But we should not miss the fact that the bar has been altogether raised to an unprecedented high level.

Another important thing to note is that the product rules are really about the nature of the disclosure required, not about whether one kind of product is ‘better’ than another. Hence, the split into the three product categories does not mean that Article 9 products are more sustainable than Article 8 or Article 6 products. It just means that each type takes a different road to sustainability. The goal is to make absolutely clear what each road looks like.

Who does what?The aim of the entire package is to channel more money towards (environmentally) sustainable investment. As a result, the regulation touches upon every single part of the investment chain: asset owners, asset managers, advisers, credit rating providers, benchmark providers and so on.

How this is supposed to work is, in principle, quite simple. If all participants show the corresponding information, end-investors will be able to see where sustainability lies and potentially invest their money there.

We can look at it from an information flow perspective (Figure 7). First, companies report on their activities. Then institutional investors (asset managers, pension funds and insurers) can take this information, use it to allocate money and, in parallel, report on how they approach sustainability in their business. Then advisers can look at which investment fund, pension, or insurance provider has the greater push towards sustainability and which products are environmentally sustainable. They can then recommend those to end-investors with a preference for sustainability. And, the final link in the chain, end-investors will be able to see from all disclosures which providers and which of their products are sustainable and/or follow adviser recommendations to buy into these products.

From a money flow perspective, it works the other way around. By making sure there is full transparency, end-investors (and, where relevant, their advisers) can easily see which providers and which products are sustainable and, if they wish, put their savings into those. This then translates into more money (financing) for the underlying holdings within these products, which are the companies themselves.

CompaniesIf end-investors are on the one end of the investment chain, companies are on the other. This is where all information originates from.

The disclosure requirements for companies currently come from two sources: the Non-Financial Reporting Directive (NFRD), which we have already touched upon in Figure 4, and the voluntary framework of climate-related financial disclosures. The latter is not officially part of the EU Sustainable Finance Agenda but it is a global standard backed by the Financial Stability Board, and the European Commission has acknowledged it in its company reporting work.

Figure 7: How can regulation channel money towards sustainable investments?

Source: Schroders. 1Includes asset managers, pension funds, and insurers.

Companies will reporthow much of what theydo contributes towards

environmentalsustainability.

NFRD and Taxonomy SFDR and Taxonomy

Market participants¹will take this informationand calculate how much

of their investmentscontribute towards

environmentalsustainability.

They will also disclosehow they think about

sustainability as a business and how

their remunerationpolicy is consistentwith integration of sustainability risks.

MiFID II/IDD suitabilityand Taxonomy

Advisers will usethe asset manager

disclosures to see whichones take it seriously andwhich of their products

are environmentallysustainable.

They will then askinvestors whether

they prefer sustainableproducts and if yes,

only two specific typesof product will getfiltered through.

More money towards environmentally

sustainable investments

Investors will:

See for themselves whichasset managers are and/

or have sustainabilityproducts and pick them.

Choose advisers/pensionfunds/insurers who have

a sustainability tilt.

Pick a sustainability productbased on an adviser’s

recommendation.

6

https://www.fsb-tcfd.org/recommendations/

https://ec.europa.eu/finance/docs/policy/190618-climate-related-information-reporting-guidelines_en.pdf

Another angle on company responsibilities comes from the Shareholder Rights Directive which approaches sustainability from another perspective: that of the dialogue between a company and its owners – in other words: stewardship. The company disclosures required relate to things that will facilitate this dialogue. One example is companies having to identify the shareholders that have a stake of more than 0.5%.

There could be additional changes if new regulation arises from the Sustainable Corporate Governance workstream. The objective here is to ensure companies do not focus too much on short-term financial performance. Examples of things under consideration include:

– Clarifying company directors’ duty of care to include all stakeholders and not only shareholders

– Extending enforcement mechanisms beyond company boards and shareholders to civil society stakeholder groups

– Tying directors’ variable remuneration to non-financial goals such as sustainability metrics

– Undertaking due diligence throughout the supply chain to cover sustainability issues such as human rights, pollution etc.

– Requiring a minimum level of sustainability expertise for companies’ boards

One thing to stress is that others in the investment chain, such as asset managers and insurers, can be companies too so all this would apply to them in addition to what we outline below.

Asset managersAsset managers are the facilitators towards a more sustainable economy because they decide to which businesses and projects to allocate money (which also goes for asset owners who manage their own assets). Their investment products are supposed to be the vehicles that will ultimately channel people’s savings towards sustainable investments, either directly, or through their institutional clients: pension funds and insurers. The centrality of their role means that almost all regulation coming out of the Sustainable Finance Action Plan one way or another affects them.

As discussed in the previous section, SFDR, the Taxonomy and the changes in the Delegated Acts require asset managers to re-think their entire business to integrate sustainability considerations to everything from operations, to risk management, to remuneration policy, to product disclosures. This includes their assessment of any adverse impacts that their products or investments altogether can have on sustainability factors. The Delegated Acts reinforce the integration of sustainability on an operational level as these rules will ensure that the necessary work happens in the background so that the corresponding disclosures emerge in the foreground.

Furthermore, there is the Shareholder Rights Directive which applies to asset managers in their capacity as an institutional investor, that is, an owner of companies, and requires them to disclose their policy on stewardship and how they have implemented it, including voting activity.

There are practical challenges to doing all this. Asset managers will need to collect a considerable amount of data. Some of this data does not exist yet, for example, the non-financial disclosures rules apply only to large listed companies and not smaller or private companies but asset managers can invest in all companies. There are further limitations where the actual investment is not a company but infrastructure projects such as buildings. The rules in this area are still being shaped.

Figure 8: Requirements for companies as the source of sustainability information

Source: Schroders.

Companies IndividualsAsset

managers

Pension fundsInsurers

Advisers

– Non-Financial Reporting Directive (NFRD): – Disclose policies on environmental protection, social

responsibility, employee treatment, human rights, anti-corruption and bribery

– Review looking to bring in changes to: include % of turnover, CAPEX and OPEX aligned with Taxonomy to quantify environmentally sustainable activities; adopt a more standardized and comparable reporting framework; extend the scope to smaller and unlisted firms

– Taxonomy: amends NFRD to include proportion of activity aligned with Taxonomy

– Shareholder Rights Directive II: intends to support greater engagement between a company and its shareholders – Director remuneration policy, shareholder vote on

remuneration policy, public announcement of related party transactions, identification of shareholders with >0.5% stake

– Taskforce for Climate-Related Financial Disclosures (TCFD): voluntary framework

– Possible changes through the Sustainable Corporate Governance workstream


managers


Advisers

Figure 9: Requirements for asset managers as the facilitators of sustainable investment

Source: Schroders.

– SFDR & Taxonomy: the intention is to make integration of sustainability risks the norm. Entity level and product level disclosures on: – The integration of sustainability risks

– Any adverse risks investments may pose on sustainability

– Stricter disclosure for products with sustainability characteristics and objective

– Delegated acts under UCITS, AIFMD, MiFID II – Integrate sustainability risks and factors within organisational,

operating and risk management processes

– Adequate governance and oversight of ESG risks

– Identification of conflicts of interest

– Add sustainability risks to risk management.

– Shareholder Rights Directive II as institutional investors – Publicly available policy on shareholder engagement

– Annually disclose how they have implemented the policy and how they have cast votes at general meetings

7

AdvisersIf asset managers are the facilitators of sustainable investment, then advisers are its gatekeepers. Advisers are those who will look into the detail of both the entity and product level disclosures from asset managers, pension funds and insurers.

Having clear flags and metrics that can be reported periodically (the same way, for example, that risk and performance are reported) is going to play an important role. That is why we can expect that product categorisations (such as the Article 6, Article 8 and Article 9 classification in SFDR) and labels (such as the Ecolabel once it is developed) will enable an unprecedented depth of discussion between advisers and end-investors.

What is interesting is that the changes that affect advisers are not limited to the new suitability rules that will see advisers ask their clients about their sustainability preferences.

SFDR requires entity and product level disclosures for advisers too, only the requirements are more tailored to the advice business. Namely, advisers must say how sustainability risk and principal adverse impact are considered in their advice. On a product level, they must disclose the likely impact of sustainability risks on the returns of the products they advise on and this actually applies to all products, not just the ones with sustainability characteristics.

Beyond that, they are subject to much of the same regulation as asset managers in terms of their entity and product level disclosures (SFDR) as well as their stewardship responsibilities as institutional investors (through the Shareholder Rights Directive).

Perhaps one notable distinction is the additional prudential regulation for occupational pension funds and insurance companies. That is currently being amended to include consideration of environmental and social factors in the prudential framework and the assessment of their financial stability as institutions. The significance of this is that it effectively recognises the potential of environmental and social factors to evolve into risks for the broader financial stability system.

Figure 10: Requirements for advisers as the gatekeepers of sustainable investment

Figure 11: Requirements for pension funds and insurers as clients and providers of sustainable investment

Source: Schroders.

– SFDR: the intention is to make advisers accountable for their business and the advice they give. They must disclose: – (Entity level) how they integrate sustainability risk in their advice

and their remuneration policy and whether they consider the principal adverse impact that their advice has on sustainability factors (or if they don’t, why not)

– (Pre-contractual disclosures for products) how sustainability risks are integrated into their advice and the likely impact of sustainability risks on the returns of the products they advise on

– MiFID II and Insurance Distribution Directive suitability rules – They will have to discuss with clients their sustainability

preferences


managers


Advisers

Asset owners - pension funds and insurersPension funds and insurers are in the interesting position where they must provide information about their business and products to their clients, that is, the end-investors. So the rules apply to them as a provider of investment products. But they are also clients of asset managers, and hence consume the asset manager disclosures on sustainability. This means that asset owners are a facilitator of sustainable investment in their own right both as a direct and indirect (via external asset managers) investor in sustainable businesses.

Given the volume of the assets within their control, if pension funds and insurers show a tilt towards sustainable investment either through their own products or through their choice of asset manager, they have a huge potential to shift money towards sustainable projects and businesses.

Source: Schroders.

– SFDR & Taxonomy – Pension funds and insurers have the same requirements as asset

managers for disclosures at both an entity and product level

– Suitability – Pension and insurance products are subject to the same

suitability process as investment funds

– Insurance advice is subject to the same requirements as investment advice

– Prudential regulation – Consider treatment of activities associated with an

environmental or social objective

– Take into account ESG risks on the financial stability of financial institutions

– Shareholder Rights Directive II as institutional investors – Publicly available policy on shareholder engagement

– Annually disclose how they have implemented the policy and how they have cast votes at general meetings


managers


Advisers

IndividualsAt the end of all this, individuals, that is the end-investors, should be able to see a clear product labelling system and have a high degree of confidence that the product does what it says on the tin.

They can also expect their adviser to ask them if they have particular preferences and have a detailed discussion on the different types of products. They will even be able to judge how their own adviser thinks about sustainability once advisers start disclosing accordingly.

But even if end-investors do not have an adviser, theoretically, they will be able to see for themselves which investment products and which product providers are sustainable or, more accurately put, follow an approach to sustainability that suits their goals and beliefs.

Hence, if end-investors have a specific sustainability preference when investing their savings, they should be able to see who in the market can offer an appropriate service.

8

The way forwardSaying that this is a learning process for everyone involved would be an understatement.

If there is a criticism for the investment industry, it is that, historically, it has not been clear enough in explaining processes, in labelling products and evidencing what it achieves. That is not to mean that it hasn’t been doing it correctly or at all. Just that it could have explained all of it better.

If there is a criticism for the regulation it is not that it is too much. To achieve the policy ambitions, regulation really has to make sure that everyone does their bit. But some aspects of the implementation could be improved. For example, although the urgency is understandably great, we need to take time to really think everything through, particularly the order of implementation. Requiring investment products to solve the equation (disclose sustainability metrics) while bits of the equation are not only unknown but missing (non-financial disclosure existing only for large listed companies) is not optimal.

At times, all these changes may seem too much. Perhaps some are too onerous, if not challenging. But the regulatory drive concentrates the mind and can, thus, accelerate the industry effort that goes into it.

The big question then is whether it will work. Besides any unforeseen hiccups with the development and implementation of all the technical detail, we identify three risks that may stand in the way of creating a sustainable investment market.

Risk 1: Forgetting that investing comes before sustainable investingThe first risk is relying too heavily on disclosures to deliver the objective. Disclosures are important for market scrutiny and to avoid greenwashing. But they do not suddenly make a market for sustainable investing.

Regulators in recent years have come to recognise that disclosure is necessary but not sufficient. We need to communicate effectively with investors, in a language which they understand and want to engage with. We have learned that it is not enough to say “here is the information, now get on with it”.

It is hoped that understanding about the difference their money can make through investing will boost the attempts to get individuals to hold fewer assets in cash deposits and invest more in capital markets. This underlies some of the thinking around another piece of EU policy: the Capital Markets Union (CMU). But simply offering them more information is not going to be enough.

As we have written in the past, most people need solutions to real life problems. Right now, they don’t see investing as part of the solution but rather as a nice-to-have that comes after having dealt with more pressing priorities such as everyday expenses and debt repayment.

If we fail in developing a framework that creates an investor culture more broadly, then there is little chance that sustainable investing will really get off the ground, at least for retail investors. Which then increases the pressure to mobilise institutional investors.

Risk 2: Following a ‘too narrow size fits no one’ approachThe second risk is regulatory standards becoming so prescriptive that:

– The sustainability bar is placed too high for anyone to reach, or

– They are not sufficiently dynamic to respond to what is a very rapidly moving area of study and research

This could take several forms.

First, it may come from turning this into a regulatory exercise which provokes a box-ticking approach rather than having financial institutions really living it, thinking for themselves and understanding what lies behind the formal rules.

Second, it may come from creating a framework which rewards businesses that have enough resources to report very detailed policies without doing the real sustainability work in the background. This is already reflected in the way some existing ESG ratings work.

Third, it may come from establishing a higher-is-better culture where the higher an ESG metric is, the better the company is perceived to be. This will not help those who may start from a lower base but still need help with their transition. After all, sustainability is not only about rewarding the best. It is also about helping those poorer performers become better or those with business models which are less sustainability-friendly to adapt. This then raises the standards across the board.

Fourth, it may come from channelling sustainable investing into too small a bucket or too narrow a definition. This would fail to take advantage of all the different ways in which an investment product can reach sustainability. There are already examples of this, such as the new disclaimer for (Article 6) products that are not promoted on the basis of an ESG characteristic or objective (see Appendix 3). This disclaimer will read: “The investments underlying this financial product do not take into account the EU criteria for environmentally sustainable investments.” This may appear to be particularly penalising for products that do integrate ESG factors but happen to not be promoted on this basis.

Risk 3: Different standards within different bordersThe third risk is forgetting that the nature of the problem (climate change) is global. After all, this is why we are seeing governments and standard-setters worldwide looking into this and developing their own framework. But if the global effort is not coordinated or aligned, then we could end up with fragmented regulation. This would defeat the purpose of creating one strong, liquid sustainable investment market.

If dialogue between investors and companies is important for sustainability, then so is the dialogue between financial market participants and policymakers, as well as the dialogue between policymakers in different countries and continents.

What next?If the last couple of years have been about shaping the new regulatory landscape, the next couple of years will mainly be about implementing all the changes. So there will still be a lot to do going forward for everyone along the investment chain. Some will have to be nudged more than others but the goal is for everyone to improve. These are the first steps in the right direction for what is ultimately going to be a long journey towards a more sustainable future.

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https://www.schroders.com/en/sysglobalassets/digital/insights/pdfs/culture-of-investing.pdf

Appendix 1

Overview of key files in EU sustainable finance regulation

Regulation Companies Asset managers Advisers Pensions/

InsurersFinancial products

Benchmark providers

Taxonomy

SFDR – Sustainable Finance Disclosures Regulation

NFRD – Non-Financial Reporting Directive

MiFID II – Markets in Financial Instruments Directive II

UCITS – Undertakings for the Collective Investment in Transferable Securities

AIFMD – Alternative Investment Fund Managers Directive

SRD II – Shareholder Rights Directive II

IDD – Insurance Distribution Directive

IFD/IFR – Investment Firms Directive/Investment Firms Regulation

IORP – Institutions for Occupational Retirement Provision Directive

Solvency II Directive

Benchmarks Regulation

Source: Schroders.

Broad regulatory timeline

2016Paris Agreement

Mar 18EU sustainable finance action

plan published

OngoingRenewed Sustainable Finance Strategy

EU Green Bond Standard

Jun 19Shareholder Rights Directive II

Jun 21Mandatory disclosures on “adverse sustainability impact”

Ap 20Benchmarks

regulation

Mar 21Disclosure regulation (Level 1)Level 2: MiFID/UCITS/AIFMD?

Q1 21New sustainable finance strategy

(expected)

Jan 22Sustainability disclosures in reports (NFRD)

Dec 21Taxonomy

Framework part I

Dec 22Taxonomy Framework part II

EU Climate Transition Benchmarks

H2 21EU Ecolabel

Source: Schroders.

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Detailed timeline of SFDR disclosures

Date Rule What Entity Product Where

10 March 2021 Article 3 Integration of sustainability risks Yes Yes Website

10 March 2021 Article 4 Consideration of principal adverse impact (comply or explain) Yes Yes Website, periodic and

pre-contractual reports

10 March 2021 Article 5 Amended remuneration policies Yes No Website

10 March 2021 Articles 6, 8, 9

Articles 6: integration of sustainability risks

Article 8: environmental and social characteristics

Article 9: sustainable investment objective

No Yes Website, periodic and pre-contractual reports

30 June 2021 Article 4(3) If >500 employees: due diligence policy on principal adverse impact mandatory Yes No Website

1 January 2022 Article 11 Product disclosures for Article 8 and Article 9 products No Yes Periodic reports

30 December 2022 Article 7 Consideration of principal adverse impact on a product level No Yes Pre-contractual reports

Source: Schroders.

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Picture 2: The environmental objectives

Appendix 2 The Taxonomy Regulation in three pictures

Six environmental objectives

Climate change mitigation

Climate change adaptation

Sustainable use and protection of water and marine resources

Transition to a circular economy

Pollution prevention and control

Protection and restoration of biodiversity and ecosystems

What does each objective mean

Stabilize or reduce or increase removal of greenhouse gas emissions

Adapt to expected climate change and its impact

Protect water and marine resources and maintain good water quality

Maintain use and value of products for as long as possible

Prevent and reduce pollution and its impact on human health

Use of land, water and other resources in a sustainable way

Example of activities in line with each objective

Producing electric charging points for cars

Researching technology for early warning systems for hurricanes

Using fewer microplastics in product manufacturing

Manufacturing products that are easier to fix than to replace; using recyclable packaging

Facilitating recycling; finding solutions for removing plastics from the sea

Having an upper limit to the number of livestock per acre

Environmentally sustainable

activity

Contributes towards at least

one objective

Does no significant harm

to the other objectives

Complies with technical screening

criteria

Complies with minimum

safeguards

This can happen in three ways: – an activity that contributes directly to the objectives– a transition activity contributing to the transition to

net zero emissions by 2050– an activity that enables other activities that

contribute to the objectives

Examples of activities that do significant harm: leading to high gas emissions, polluting the environment, generating a lot of unnecessary waste, harming protected species or habitats.

The activities must meet technical performance thresholds that determine if an activity contributes to an objective or whether it causes significant harm to an objective.

– OECD Guidelines for Multinational Enterprises– UN Guiding Principles on Business and Human Rights– The International Bill of Human Rights– The Declaration of Fundamental Rights and Principles

at Work

Picture 1: Taxonomy feeding into other regulation

Source: Schroders.

The Taxonomy itself does not translate directly to any requirements but connects to other pieces of regulation: 1. Changes what qualifies as a sustainable product in the


– This particularly affects disclosures of investment products

2. Changes what non-financial information companies need to report in their accounts as per the Non-Financial Reporting Directive (NFRD)

– It will ask companies to report % of turnover, CAPEX and OPEX aligned with the Taxonomy (this should help disclosure at an investment product level in SFDR).

3. Connects to other parts of the Sustainable Finance Action Plan: the Green Bond Standard and the Ecolabel

4. Will connect to future policy

Taxonomy

Disclosures Regulation

(SFDR)

Non-Financial

Reporting (NFRD)

Green Bond

StandardEcolabel

Future policy and regulation

The Taxonomy itself does not translate directly to any requirements but connects to other pieces of regulation: 1. Changes what qualifies as a sustainable product in the


– This particularly affects disclosures of investment products

2. Changes what non-financial information companies need to report in their accounts as per the Non-Financial Reporting Directive (NFRD)

– It will ask companies to report % of turnover, CAPEX and OPEX aligned with the Taxonomy (this should help disclosure at an investment product level in SFDR).

3. Connects to other parts of the Sustainable Finance Action Plan: the Green Bond Standard and the Ecolabel

4. Will connect to future policy

Taxonomy

Disclosures Regulation

(SFDR)

Non-Financial

Reporting (NFRD)

Green Bond

StandardEcolabel

Future policy and regulation

Picture 3: What makes an activity environmentally sustainable

Source: Schroders.

Source: Schroders.





















































































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Appendix 3 SFDR in three tables

Table 1: Overview of required disclosures

Sustainability risk to investment Investment risk to sustainability Sustainability product features

Entity level Entity level Product level

– Policy on integration of sustainability risks into investment decision making (website)

– Amend remuneration policy to explain how the policy is consistent with integration of sustainability risks (website)

– Statement on due diligence policy on how they consider principal adverse impact (PAI) of their investment on sustainability factors (website)

– OR if PAI is not considered: explanation why this is the case and whether they plan to consider it in the future (website)

Amend pre-contractual document to include:

– Art. 8 products: how sust. characteristics are met; if there is a benchmark, how it is consistent with these characteristics

– Art. 9 products: how the benchmark is aligned with that objective and how/why it differs from a broad market index; OR if no benchmark: explain how the objective will be achieved; if objective is reduce carbon emissions: how it relates to Paris Agreement goal

Art. 8 & 9 products: make above information available on websiteAmend periodic reports to:

– Art. 8 products to explain how characteristics are met

– Art. 9 products how the impact compares to impact of benchmark and impact of broad market index

Product level Product level

Amend pre-contractual document to include:

– How sustainability risks are integrated

– How sustainability risks are likely to impact the product’s return

Amend the pre-contractual document to explain:

– Whether and, if so, how a product considers PAIs on sustainability factors

– A statement that information on PAI is included in the corresponding periodic reports

– OR if PAI is not considered: include a statement that this is the case and explain why that is

Source: Schroders. Advisers have to comply with the first two columns (sustainability risk to investment and investment risk to sustainability) but in respect to their advice and the products they advise on.

Table 2: What applies to whom

Participant

Entity Product

Website

Pre-contractual Periodic report Website

All products

Article 8 and 9

productsAll

products

Article 8 and 9

products

Article 8 and 9

products

Integration of sustainability

risksRemuneration

policy

Principal adverse impact

Integration of sustainability

risks

Principal adverse impact Disclaimer

Additional details

(see below) Disclaimer

Additional details

(see below)

Additional details

(see below)

Asset managers

Providers of occupational pensions

Providers of personal pension funds

Funded state pensions

Up to each country to decide if they want to do this

Insurers

Advisers

Advisers with <3 employees

NONE

Source: Schroders. Includes investment firms, UCITS management company, AIFMs, managers of venture capital funds.

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Table 3: A snapshot of product disclosures

Product

Pre-contractual Periodic report Website

All products Article 8 and 9 products All productsArticle 8 and 9 products

Article 8 and 9 products

Integration of sustainability risks

Principal adverse impact

Disclaimer for non Article 8 and 9 products

Additional detailsDisclaimer for non Article 8 and 9 products

Additional details Additional details

Article 6 Yes Yes “The investments underlying this financial product do not take into account the EU criteria for environmentally sustainable investments.”

- “The investments underlying this financial product do not take into account the EU criteria for environmentally sustainable investments.”

- -

Article 8 Yes Yes - How characteristics are met To what extent characteristics are met

Description of the characteristics

If there is a benchmark, how it is consistent with the characteristics

% of assets in line with Taxonomy

Methodology used to monitor characteristics


Disclaimer: “The ‘do no significant harm’ principle is applied only for the investments underlying the product that take into account the EU criteria for environmentally sustainable investments. The investments underlying the remaining portion of this financial product do not take into account the EU criteria for environmentally sustainable investments.”

Information in pre-contractual and periodic reports

Disclaimer: “The ‘do no significant harm’ principle is applied only for the investments underlying the product that take into account the EU criteria for environmentally sustainable investments. The investments underlying the remaining portion of this financial product do not take into account the EU criteria for environmentally sustainable investments.”

Article 9 Yes Yes - If there is a benchmark, how it is aligned with objectives and how it is different from broad index

The sustainability impact Description of the objectives

If no benchmark, how the objective will be achieved

Comparison of product's impact with impact of benchmark (if any) and impact of broad index

Methodology used to monitor impact



Information in pre-contractual and periodic reports

Source: Schroders.

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